Email this article	Comment on this Article	Print this article

With rising risks to financial and economic stability, SARB should be raising interest rates

“A flight to sanity.” This is how a New York-based trader aptly described the recent turmoil in global financial markets, and in view of my often-expressed uneasiness regarding the exuberance in more risky assets in recent months I can only concur.

At the time of writing volatility is still the order of the day, and making definitive statements about where it will all end is a risky business. It does however appear as if heightened volatility will be with us for a few more months. Uncertainty regarding the future path of US monetary policy needs to be resolved, and investors need more time to adjust their positions in relatively illiquid markets.

One thing seems sure, however. I have maintained for some time now that risk is not priced correctly because of excess global liquidity, the savings glut, the search for yield or whatever way one chooses to describe the cause of this development. Recent volatility has forcefully brought this point home, and it is unlikely that risk premiums will revert to their previous low levels that have proved to be unsustainable.

Where will this leave South Africa? Much has been made of our improved fundamentals, and justifiably so. I nevertheless do not believe that South Africa will be immune to a global adjustment in commodity and emerging markets, and our improved fundamentals will unfortunately not offer much protection to financial markets.

After all, South Africa runs a relatively large and growing current account deficit, and one of the dominant themes in the recent sell-off has been the extreme vulnerability of countries that are relatively more dependent on foreign capital inflows to keep their economies on an even keel.

Perhaps South Africa’s improved fundamentals will help to cushion the impact of developments in financial markets on the real economy. But this will largely depend on the extent and pace of the adjustment in the exchange rate of the rand that now seems inevitable, and the monetary policy response that may be required.

The international economic background

The sudden change in financial market sentiment since the second week of May has its origin in a range of international developments.

• The primary mover has been the realisation in markets that they have perhaps been too complacent regarding the risk of rising inflation, and the possibility that central banks, in particular the US Federal Reserve, could increase interest rates beyond the peaks currently priced in by the markets. Inflation risk has therefore now been transformed into growth risk, impacting on all asset prices that are dependent on a continuation of solid global growth, viz. commodities and emerging markets. The US housing market will continue to be watched carefully for any weakness that will suppress household spending. It is furthermore still unsure whether China, the other engine of global growth, will be able to stear its overheated economy to a soft landing.
• The uncertainty regarding the outlook for monetary policy, and the perceived risk of a policy error (in so far as the Fed could push the economy over the brink by continuing to hike the federal funds rate even though the economy is showing signs of slowing), is being exacerbated by having an untested governor at the helm of the Federal Reserve, whom markets have yet to come to know and understand. Although Ben Bernanke will probably in time prove to be a very capable central banker, the timing of his introduction to his new position has been unfortunate. His predecessor, Alan Greenspan, managed to convince markets that he knew exactly what was happening and why and the direction things were headed. Bernanke unfortunately creates a sense of uncertainty, and he has yet to learn the fine art of interacting with financial markets.

• There is ample evidence of over-exuberance in commodity markets in the past 12 months (see the graph below). A rush of investment interest from people who have little if any knowledge and experience of commodity markets has dominated demand for commodities. Commodity prices therefore became increasingly removed from the underlying balance between physical demand and supply, and momentum investors started bolting for the exit at the first sign of trouble.
• The same comments apply by and large to emerging markets, especially equities. The inflow of capital into these markets in the early months of 2006 has been astonishing, approaching the level of inflows for the full 2005 calendar year. The bulk of the money came from retail investors, and not from the safe hands of institutions, setting up emerging equities for the eventual correction. Hedge funds also played a destabilising role.
• The underlying structural argument in favour of commodity and emerging markets however remains intact. The current correction has more to do with a removal of unjustifiable and therefore unsustainable froth in financial markets, than what it reflects a deterioration in the underlying economic outlook. Most emerging-market countries have used the favourable conditions of the past three years to strengthen their economies structurally, specifically their external accounts, which should enable them to weather the storm better than in the past. Unfortunately this argument also serves to highlight the anomolous situation of those countries running sizeable current account deficits, viz. Hungary, Turkey, South Africa and a few others.

The South African economy

Introduction

No one will deny that the South African economy has performed admirably in the past three or four years. Evidence of an improved growth environment is there for all to see.

However, in the previous edition of this review, I made the following statement: “The extent to which the boom conditions of 2005 can be ascribed to an improving structural domestic economic background, rather than extremely favourable international tailwinds resulting from a commodities boom which is bound to subside eventually, still needs to be tested. The answer to this question will determine the sustainability of the current upswing.”

Recent developments indicate that we have arrived at the moment of truth, and that we will know the answer to this question within the next 12 months, if not before the end of this year.

The key will be what impact the changing global environment is going to have on capital flows to South Africa, and therefore on the exchange rate of the rand. Although Government continues to emphasise that higher economic growth is South Africa’s first priority, and rightly so given the unemployment and poverty challenges, events beyond Government’s control can yet force it to temporarily allow issues of stability to take precedence, and to accept a cyclical slowdown as inevitable in order to preserve the gains to South Africa’s potential growth rate.

Economic growth

The economy rebounded convincingly in the first quarter of 2006 after a rather disappointing end to 2005. Gross domestic product expanded at a quarter-on-quarter, seasonally adjusted and annualised, rate of 4,2% (4,7% excluding agriculture), compared with 3,2% in Q4 2005. The year-on-year growth rate was 4%, which is in line with the recent assessment of the Reserve Bank of South Africa’s potential growth rate, indicating an absence of price pressures from the output gap.

A welcome development was the strong recovery in growth in the manufacturing sector that, in combination with a marked slowdown in the wholesale and retail trade, hotels and restaurants category, points to a better balance in economic activity, which should benefit the current account of the balance of payments in time.

Looking ahead, it still appears likely that the economy will grow by 4% - 4,5% in 2006, and similarly in 2007. Although an upward revision to past GDP statistics in November 2006 may yet push up the growth rate for 2006, this will merely be of a technical nature. The risk is rather to the downside should the Reserve Bank be forced to tighten monetary policy in response to greater depreciation in the rand than what is deemed acceptable to avoid jeopardising the inflation target.

Rand exchange rates

“The rand is therefore likely to remain relatively strong as long as the commodities boom continues, but the risk of a fallout is rising.” This was my closing comment on the rand in the previous review, and the relevance of these words has certainly been demonstrated by recent events in the currency market.

The rand lost 7,2% of its value on a nominal effective basis during May 2006, and an even greater 10,3% against the US dollar. As predicted, the underlying reason for the weaker rand has been the fall in commodity prices initiated by fears of slower global growth ahead, and the negative impact this has had on equity portfolio investment flows. As mentioned above, these events were exacerbated by the flight of weak investors from these markets.

South Africa’s current account deficit is once again in the spotlight and will be closely watched in coming months. Indications are that the deficit increased to 5%+ of GDP in Q1 2006, although that could possibly prove to be the turning point. It nevertheless remains to be seen how markets will react if the Reserve Bank were to announce a deficit of this magnitude at the time of the release of its June 2006 Quarterly Report.

The recent depreciation of the rand is therefore welcome in so far as it will contribute to a market-driven improvement in the current account. The question is whether there will be an orderly adjustment in foreign exchange markets, or a sudden sharp move that could spin out of control.

The risk to the rand is being complicated further by the uncertainty regarding the outlook for the US dollar. One’s first reaction is to conclude that a weaker dollar will be supportive of a stronger rand, but a sharp, disorderly fall in the value of the dollar that destabilises global economic activity could result in the rand being overwhelmed by a deteriorating global growth outlook.

It also needs to be reiterated that higher interest rates will probably be negative for the rand because of its depressing effect on economic growth and equity portfolio flows.

Inflation

Inflation has surprised positively in the last couple of months, and at 3,7% the CPIX inflation rate remains well anchored within the 3% - 6% target band of the Reserve Bank. A welcome development is the convergence in the inflation rates for different components of the consumer price basket, especially the sharp decline in services inflation from approximately 6% a year ago to its current level of 3,5%.

This development has probably played an important role in the decline in inflation expectations to the mid-point of the target range, which can be interpreted as a reflection of the enhanced credibility of monetary policy.

So far the economy has been able to absorb the renewed surge in oil prices and higher food prices quite well, with a relatively strong rand holding any inflationary consequences at bay. And that is of course where the crunch lies – inflation will probably be contained as long as the rand remains relatively well behaved (i.e. not weaken rapidly beyond a level of R7/$), but as in the past a sharp depreciation in the rand is unlikely to bypass domestic prices (see the graph).

Interest rates

I have argued elsewhere (see my “Economic Commentary” of 3 May 2006) that the current wide inflation targeting band of 3% – 6%, especially the high upper boundary, is resulting in sub-optimal monetary policy setting. In view of rising risks to financial and economic stability, the SARB should be raising interest rates, but it is prevented from doing what the MPC probably regards as the appropriate action by inflation being well inside the target range.

It is of course true that promoting higher economic growth is South Africa’s first priority at this point in time, and it is exactly for this reason that Government is reluctant to lower its inflation target.

Tax relief to households totalling R12 billion announced in the 2006/07 national budget, flying in the face of the budget’s stated claim that it is aimed at offsetting the impact of robust consumption expenditure on the current account deficit, is further proof of scant regard on the side of Government for the Reserve Bank’s dilemma.

In its May 2006 Monetary Policy Review the Reserve Bank stated that what is at issue is how pre-emptive the MPC should be in the face of risks that may not come to pass, although they are increasing. Should a hike in interest rates eventually prove to have been unwarranted, the Reserve Bank runs the risk of being accused of unnecessarily suppressing economic growth.

It is for this very reason that I believe the MPC will wait somewhat longer before it responds to the recent turmoil in the financial markets and adopt a wait-and-see attitude, specifically with regard to the exchange rate of the rand.

The key factor to watch in coming months will therefore be the exchange rate. A rapid depreciation of the rand beyond R7/$ will leave the SARB with no option but to hike the repo rate. In the light of my view expressed above that the cycle has probably turned for commodity and emerging markets, I am of the opinion that global developments are likely to force the MPC’s hand eventually.

The question then becomes by how much the SARB will have to raise the repo rate to achieve the desired effect on domestic demand. The surge in household debt from a low of 50% of disposable income in 2002 to 65% currently, which one must bear in mind was not uniform across all households, indicates that although debt service levels are still well contained, a relatively small increase in interest rates could rapidly slow the rate of credit expansion. The repo rate is therefore unlikely to rise by more than 1 to 2 percentage points, unless we have a real blowout in the currency market.

Financial markets

The cautious stance to financial markets that I advocated in the February 2006 issue of this review might have been marginally premature, but its validity has certainly been borne out by recent events. There has, however, been a notable divergence in the behaviour of the equity and bond markets.

In the case of equities, the JSE All Share Index closed the month 6,9% below its peak achieved on 11 May 2006, having been down 11,1% at one stage. This is a remarkably better performance than for emerging markets as a whole, with the Morgan Stanley Emerging Markets Free Index being 14,8% below its peak at the end of May, having barely recovered from its intra-month low. (See the graph.)

However, the bond market has been a different story. The yield on a generic 10-year government bond rose from 7,4% at the beginning of May to 7,75% at the end of the month, but unlike the equity market did not experience a late-month recovery. When compared to trends in emerging markets, bonds have therefore behaved in the opposite way to equities. The JP Morgan Emerging Market Bond Index Plus Spread widened from 173 basis points to 225 at its worst in May, but it has since recovered to 209 basis points, i.e. the SA bond market followed emerging markets down but did not share in the latter’s recovery.

The reason for this dichotomy is probably to be found in the continued depreciation of the rand. This explains why the recovery in equity prices was concentrated in the resources sector. But a weaker rand raises the spectre of increased inflation risk and the possibility of monetary policy being tightened in response; hence the unabated upward pressure on bond yields.

Offshore assets have of course gained a new lease of life because of rand depreciation and the possibility that this is not yet done.

Ultimately it thus boils down to the same question for the financial markets and the real economy: what will happen to the rand exchange rate in coming months? As past experience has indicated, the exchange rate is the most difficult to forecast of all the salient economic variables.

It is time to fasten our seat belts!